Properly Analyzing Cash-on-Cash Returns in Real Estate Investing — Tactica Real Estate Solutions (2024)

The cash-on-cash return in real estate investment is a misunderstood metric in the real estate industry. Today I plan on diving deep into the Tactica methodology, and how it differs from other calculations, you may come across.

Contents

1. Definition

   • Good Cash-on-Cash Return

2. Cash-On-Cash Formula (Advanced)

3. Categorizing Cash Flows

4. Reevaluating Cash-on-Cash (Annually)

5. Best Uses

6. Video: Uncomplicating the Cash-on-Cash-Return

Cash-on-cash in its simplest form, you’d calculate it:

AnnualCash Flow/Total CashInvested

If you invested $100,000 in aninvestment propertyand reasonably expected to earn $6,000 incash flowafterdebt servicein Year 1, your cash-on-cash returnwould be 6%.

$6,000 / $100,000 = 6%

Some ambiguity can rear its ugly head when determining what qualifies ascash flowvs. cash invested.

For example:

• If you need to pay for a new roof out of pocket, should that be considered a decrease inannualcash flowor an increase intotal cashinvested (an adjustment to the numerator or denominator)?

• If you refinance a mortgage and are fortunate to receive excess cash proceeds, should this be counted as an increase inannualcash flowor a decrease intotal cashinvested?

• Canannualcash flowbe considered a reduction inthetotal cashinvested?

Tactica's definition of cash-on-cash return strives to help answer the above questions. The cash-on-cash returndoes not measure thetotalreturnon investment because it is an annual yield.

Cash-on-Cash Return = Yield Metric

In the article "A Definitive Guide to CalculatingReal EstateReturns," yields are defined as:

Yields won't factor in appreciation and loan paydown, which will have a massive impact on the overall success of the investment. Simply put, you can realize good cash-on-cash returnsannually and still have the investment fail if you can't sell it for more than your purchase.

Another example of a yield is thecapitalization rate(cap rate), which takes:

NOI/Purchase Price

Cap rates serve as a metric to benchmark a property valuation vs. other comparable sales in the marketplace. They’re meant to measure the pricing attractiveness given the historical operations but can’t determine the overall success of an investment.

Generally speaking, if the cash-on-cash return is higher than the actual proforma cap rate, you should feel confident in the upside of your potential investment.

Cash-on-Cash Return > True Proforma Cap Rate = Good

With rising interest rates, you’ll commonly hear of real estate investors taking on negative leverage in the current investment environment. Negative leverage is when the loan constant exceeds the actual proforma cap rate. In these instances, leverage hurts property yields, and the cash-on-cash return will be lower than the cap rate.

In other words, high pricing and expensive debt wreak havoc on potential returns. Maximizing the cash-on-cash return will hinge on paying below market value for your real estate transaction and improving property management to grow income and cut expenses.

General real estate market knowledge of various asset classes within the submarket will be crucial to best determine reasonable cap rates and cash-on-cash return metrics for a potential investment opportunity.

Total Return Measures

On the other end of the spectrum, metrics that measuretotal returnare:

• InternalRate of Return(IRR)

• Equity Multiple

• AnnualizedRate of Return(ARR)

These metrics will take into account appreciation and loan paydown and will paint a detailed picture of the overall success of the investment.

The cash-on-cash equation I presented before was oversimplified:

AnnualCash Flow/Total CashInvested

I want to touch on both the numerator and the denominator.

Numerator: AnnualCash Flow

You can break down annual pre-tax cash flow further into:

Operating Revenues - Operating Expenses- Debt Service

So,annualnet cash flowis yourrecurringrevenue, expenses, andmortgage payments. Revenue will be rents, ancillary income, fees, and negative adjustments for vacancies and rental concessions. Recurring costs would be marketing, maintenance (not an improvement), insurance, property taxes, and utilities. Debt service is what you owe the lender each year in principal and interest payments.

Denominator: Total CashInvested

Total cash invested will be affected by things like:

• Capital expenditures

• Refinance proceeds

• Unordinary one-time expenses (such as loan origination fees andclosing costs)

These items will affect the denominator and be consideredtotal cashinvestedin the cash-on-cash formula.

Total CashInvestedcan be broken down further into:

Down Payment+ Closing/Loan Costs + Capital Investment

CAPEX will increase the denominator, which means your actual cash investment increases (you increase the total cash basis in the investment). On the flip side, refinance proceeds would reduce your amount of cash in the project (reduce the denominator) because you would get a chunk of your initial investment back.

The image below may help determine how various expense items should be classified.

You may wonder how I determine annualcash flowvs. thetotal cashinvested.

In reality, the IRS determines this. While there may be gray areas when determining how an expense should be classified, any expense that prolongs the life of an investment is typically considered CAPEX. The IRS won't let you deduct 100% of these expenses the year you incur the cost; instead, you must depreciate them over a predetermined number of years.

• Spend $100,000 replacing the roof: Your denominator increases.

• Spend $55,000 on replacing plumbing fixtures: Your denominator increases.

• Raise rents over the past year: Your numerator increases.

• Fix the furnace: Your numerator decreases (as long as you didn’t replace the furnace, then the denominator would increase)

• Refinance and get $50,000 back of our original $100,000 investment? Your denominator decreases by 50%. The IRS considers a refinance a return of investment principal, not taxable profit.

Disclaimer: Always verify with your accountant how expenses should be classified, as every tax situation differs vastly.

Year 1:You make a $500,000down paymenton arental property.Closing costsand loan origination fees total $7,000, which you'll pay out of pocket. Your project's annualrental incometotals $120,000.Operating expensesare projected at $55,000. The loan is interest-only for the first two years, and theinterest paymenttotals $20,000 annually.

Cash-on-Cash Return= ($120,000 - $55,000 - $20,000) / ($500,000 + $7,000)

= $45,000 / $507,000

= 8.98%

Year 2:Rental incomeincreases to $125,000,operating expensesdecrease to $53,500, and the interest-only payment is still $20,000 annually. Two water heaters break and cost $2,500 to replace.

Cash-on-Cash Return= ($125,000 - $53,500 - $20,000) / ($507,000 + $2,500)

= $51,500 / $509,500

= 10.11%

Year 3:Rental incomeincreases to $126,700,operating expensesrise to $57,000, and the loan begins to amortize.Debt serviceis now $28,700. You did a significant landscaping project that cost $7,500.

Cash-on-Cash Return= ($126,700 - $57,000 - $28,700) / ($509,500 + $7,500)

= $41,000 / $517,000

= 7.93%

Year 1:You make a $500,000down paymenton arental property.Closing costsand loan origination fees total $11,000, which you'll pay out of pocket. You estimate $140,000 in renovation costs to update all the units.

You secured a construction loan that you can draw down during construction. You will pay interest only. You do not expect anycash flowin Year 1, as all units will be vacant while you renovate the property. You will be on the hook to pay interest and draw fees, and other holding costs out of pocket, totaling $33,400 in Year 1.

Cash-on-Cash Return = -33,400 / $511,000

= -6.536%

Property taxes, insurance, and utilities during the renovation will lead to a negativenet operating income. There will also be financing costs, which will lead to negative cash-on-cash yield during the construction Years.

Year 2:You can lease the freshly renovated units and get $144,000 inrental income.Operating expenseswill total $67,800. With the property stabilized, you refinance the construction loan into permanent financing. Blowing out the construction loan gives you $420,000 in repayment via refinancing proceeds. Permanent debt coverage costs $34,000 annually.

Cash-on-Cash Return= ($144,000 - $67,800- $34,000) / ($511,000 - $420,000)

= $42,200 / $91,000

= 46.154%

Note: You financed the $144,000 renovations; therefore, the monies spent didn't count as an additionalcash investment. If this were an all-cash purchase without financing, you’d add the $144,000 to the denominator.

There's a pretty stark contrast between Year 1 and Year 2. This volatility proves that the cash-on-cash returnmay not be the best metric to use when analyzing a capital-intensive project like a fix & hold.

The two examples above were meant to lay out two very different investment scenarios where cash-on-cash calculationsvaried wildly.

Cash-on-cash is a great metric when the purpose of the investment isannualcash flows(preferably predictable) vs. projects banking on forced appreciation.

Cash-on Cash-Effective When Analyzing:

• Commercialreal estate,such as retail, office, and industrial, will have long-term leases in place and predictablecash flow

• Stabilized multifamily or any turnkey investment

  • Quickly “qualifying” or “disqualifying” an investment opportunity

• Real estaterequires modest capital spending

Cash-on-Cash NOT as Effective When Analyzing:

• Fix & Flip/Hold investment opportunities

• Ground-up development

• Redevelopment

Occasionally, the cash-on-cash metric can be helpful on a project with a refinance, but it will never be my go-toannual returnmetric.

Summarizing the Cash-on-Cash Return

Hopefully, you have a better idea of how Tactica calculates the annual cash-on-cash return. It is a yield metric that measures your return over a defined period. This cash-on-cash return is in constant flux when revenues and expenditures are correctly categorized, and you should reevaluate it annually.

The cash-on-case return is helpful when future cash flows are largely predictable and stable. It is less valuable for extensive renovation projects, development, or quick fix/flip projects that expect a significant refinance or sale shortly after closing.